Organizations increasingly want to better understand their revenues and costs and, in particular, the behavior of factors that drive these top and middle lines of the bottom-line profit equation. The reason for increased interest in more detail is obvious: The margin for decision error is getting slimmer. Mistakes in poor product selection, wrong channel options or improper customer targeting can no longer be offset by good choices made elsewhere in a business.

What questions might managers and employee teams ask about their customers that can be answered with detailed profitability reporting? Here are some examples:

  • Do we push for volume or for margin with a specific customer?
  • Are there ways to improve profitability by altering the way we package, sell deliver or generally serve different types of customers?
  • Does the customer's sales volume justify the discounts, rebates or promotion structure we provide to that customer?
  • Which products are relatively more profitable to cross-sell or up-sell?
  • Can we realize the benefits from our changing strategies by influencing our customers to alter their behavior to buy differently (and more profitably) from us?
  • Can we shift work to or from some of our suppliers based on who is more capable or already has a superior cost structure compared with ours?

Risks from Inaccurate Cost Calculations

Companies plan and control their operations using accounting information that is assumed to accurately reflect the costs of their products and standard service lines. In fact, this is often not the case. The recorded expenses, such as salaries and supplies, may be exact in their amounts because they are externally audited and automated accounting systems capture them - but the problem is then transforming those expenses into their calculated costs of the business processes and the products that, in turn, consume those process costs.

The costing systems of many companies, with their aggregated summaries and their broad averaging allocation of indirect costs, mask reality with an illusion of precision. In fact, traditional cost systems typically provide misleading information to decision-makers with minimal transparency to understand what constitutes a product's cost.

To further complicate matters, with the shift in attention from products to customer services, managers are also seeking granular "costs to serve" customer-related information. These are not all the costs related to making a product or delivering a standard service line (e.g., a bank checking account), but rather they are the costs from interactions with customers, such as a help desk call. The problem with accounting's traditional gross profit margin reporting (i.e., restricted to only product cost profit margins) is managers cannot see the bottom half of the total picture - all the profit margin layers eroded from distribution, selling, credit, payments and marketing costs.

The unacceptable result of not converting these types of expenses into customer costs is that executives, managers and employee teams receive incomplete profit reporting that is not segmented by customer; and the product profitability data they do receive is flawed and misleading. They deserve fully loaded cost and profit reporting that encompasses all the traceable expenses of their end-to-end value stream costs - from supplier-related purchasing to customer service. How can recent advances in managerial accounting methods and technology deploy the vast potential that companies have from their business intelligence systems?

The Quest for Individual Customer Profit Reporting

Businesses with thousands of customers want to scale up their cost and profit reporting and visibility at the individual customer level, but their costing systems cannot accomplish this. As a result, organizations lack the essential information for making much better decisions about product mix, customer mix, marketing, channel strategies and sales programs.

To better analyze revenue, cost and the resulting profit margin information, businesses need to be able to define segmented reports on the fly. This includes tracking profit for different time periods by individual customers, by individual products, and by specific sales channels, distribution channels, branches, service centers or sales outlets. To enhance the identification and investigation of problems, organizations also need the flexibility of at-a-glance and drill-down views to see costs and profits with fine granularity.

In order to overcome the limitations of traditional costing systems - which are hampered by their monthly aggregations of direct costs, excessively simplified cost allocations and resulting lack of visibility for indirect costs - organizations have been adopting transaction-based costing systems. This type of system is based on cost modeling that traces an organization's expenses - both direct and indirect - into the products, services, channels and customers that cause those expenses to be incurred.

The attraction of effective transaction-based costing system is that it can economically scale to accommodate billions of transactions, access data from diverse multiple source systems, and be deployed for remote Web-enabled analysis. It reports validly calculated profits on a moment's notice rather than two weeks after a month has ended. As a bonus, with projected sales volume and mix, it enables reliable what-if scenarios for test-and-learn as well as pro forma profit-and-loss forecasts.

Measuring Customer Lifetime Value

Some organizations have evolved beyond using transaction-based costing solely for obtaining more accurate and relevant historical cost and profit margin information. For these more capable companies, the emphasis has shifted from just measuring costs to measuring long-term potential customer profitability, referred to as customer value management. These organizations use an understanding of their pricing and cost drivers - the measures of work activity that are causal factors in the incurrence of cost - to improve their future operations and profit performance. They leverage their improved understanding of their customers' sensitivity to varying price levels and of their own cost structure, which is made more highly visible with transaction-based costing. With this higher understanding of customer lifetime value (CLV), they proactively manage their resources and induce customer responses (e.g., deals, offers, discounts) to enhance the key elements of value creation from the customer's perspective.1 Organizations involved in business process reengineering, quality improvement, and lean management initiatives also use both the financial and nonfinancial insights from their transaction-based cost measurement systems to increase productivity.

Profitability management should ideally be based on transaction-based costing.2 Profitability reporting at a detailed level gives a meaningful business context to the realm of business intelligence (BI). In the end, managerial accounting is just data. It is to be used as a means to an end - namely decision-making. The quality and accuracy of managerial accounting data is therefore critical.

Computer Technology Enables Transaction-Based Costing

A revolution has occurred in computer technology that allows large-scale and detailed profitability reporting. In the past, achieving ever-higher levels of cost accuracy were simply not justified given the extra work involved. But today, applying computer technology converts that administrative effort to near zero (after the automated cost system is initially designed and configured). Further, data storage capacity is now economical. As a result, the new principle for attaining highly accurate cost and profit information is to measure price and costs consumed at the moment a consumer pays - at the instance of a transaction.

At this intersection in time, value is exchanged between a buyer and seller. This type of costing is a "bottom up" or "pull" approach. That is, the customers and products are placing demands (or pulling) on the business processes that are in turn drawing on the resource expenses. It is a consumption view of costs.

The accepted profit equation becomes:

Individual customer profit = the sum of transactions (price - [unit cost rate x quantity] ) - other traceable customer costs

Figure 1 illustrates the information system design for transaction-based costing. The "transaction assignment modeler" is the cost calculator that serves as the central application to compute the profitability information. It is the heart of the methodology. This is where all the user-defined rules, selection criteria, data cube design and formulas can be chosen and customized to enable flexible analysis by the casual user.

Figure 1: Transactional-Based Costing Information System

The two main source data at the left of the figure are 1) customer purchase history from the sales order management system for the top-line revenues and product costs (i.e., quantities purchased) and 2) operational systems, such as an enterprise resource planning (ERP) system, for product and "costs to serve" events driver quantities.

Unit costs per product or per event are retrieved from the separate input files at the top of the figure. The challenge with these files is less about high accuracy, but rather knowing what elements of expenses to include or exclude in the unit cost rates. For example, in quoting a one-time order, one could arguably exclude equipment depreciation as an irrecoverable sunk cost; but for a long-term customer contract, one would likely include that expense.

Achieving Extreme High-Cost Accuracy

With regard to cost accuracy, this bottom-up approach quickly calculates high accuracy for measuring individual customer profitability because the two easiest elements in the profit equation to capture, each transaction's price and quantity (in italics in the profit equation above), are the factors that influence the majority of the total accuracy. In contrast, a modest error in any individual unit cost rate (e.g., $25 per bank deposit + /- 5 percent error) will not substantially create as much total cost error as errors in price and quantity do.

Because most businesses today have automated transaction and production systems, the data that costing error is sensitive to is already accurately captured.3This means customer profitability information can be instantly reported at any time on demand. This provides robust information for customer profit analysis.

Future competitive differentiation will be based on the rate of speed at which organizations learn, not just the amount they learn. Having all this revenue, cost and profit margin data is only a beginning. People have to act on and make decisions with the data. But in the land of the blind, the one-eyed man is king.

References:

1. For more about customer lifetime value, read the DM Review article published June 30, 2005, "Can Performance Management Accomplish What Einstein Couldn't?" http://www.dmreview.com/article_sub.cfm?articleId=1031537

2. As an interim step, activity-based cost management systems can provide customer profitability information, however, with less accuracy.

3. For advanced systems, there are extraction, transform and load (ETL) tools that are applied for input data cleansing to assure higher accuracy of the calculated and reported information.